Liquidity
Management
22
Corporate Financial Management 3e
Emery Finnerty Stowe
© Prentice Hall, 2004
Working Capital Management
Working capital
= current assets – current liabilities
Working capital management refers to
choosing the levels and mix of:
cash, marketable securities, receivables and
inventories.
 different types of short-term financing.

Considerations in Working
Capital Management
Sales impact
Liquidity
Relations with stakeholders
suppliers
 customers

Short-term financing mix
profitability
 risk considerations

Working Capital Management
Maturity matching approach
Conservative approach
Aggressive approach
Maturity Matching Approach
Hedge risk by matching the maturities of
assets and liabilities.
Permanent current assets are financed with
long-term financing, while temporary
current assets are financed with short-term
financing.
There are no excess funds.
Maturity Matching Approach
$
Temporary Current Assets
Short Term
Financing
Long
Term
Financing
Time
Conservative Approach
Long-term funds are used to finance both
permanent as well as some temporary shortterm assets.
When there are excess funds, they are
invested in marketable securities.
Conservative Approach
$
Temporary Current Assets
Marketable securities
Short Term
Financing
Long
Term
Financing
Time
Aggressive Approach
Use less long-term and more short-term
financing than the conservative approach.
Aggressive Approach
$
Temporary Current Assets
Short Term
Financing
Long
Term
Financing
Time
Cost and Risk Considerations
Yield curve is usually upward sloping.
Short-term rates are more volatile than longterm rates.
Firm's ability to obtain needed short-term
financing.
Cash Conversion Cycle
The cash conversion cycle is the length of time
between payment of accounts payable and the
receipt of cash from accounts receivable.
Cash Conversion Cycle
Purchase
Inventory
Sale on
Credit
Inventory Conversion Period
Collect Acct.
Receivable
Receivables Collection
Period
Time
Payables
Deferral Period
Payment of
Accts. Payable
Cash Conversion Cycle
Cash Conversion Cycle
Cash
Inventory
Receivable s
conversion  conversion  collection
cycle
period
period
Payables
 deferral
period
Inventory Conversion Period
The inventory conversion period is the length of
time from the purchase of inventory to the time
the sales are made on credit.
Inventory
Inventory
365
conversion 

Cost of Sales/365 Inventory turnover
period
Receivables Collection Period
The receivables collection period is the
average number of days it takes to collect
on accounts receivable.

Equal to days sales outstanding (DSO)
Receivable s
collection
period
Receivable s
365


Sales/365
Receivable s turnover
Payables Deferral Period
The payables deferral period is the average
length of time between the purchase of
materials and labor and the payment of cash
for the same.
Payables
deferral 
period
Accounts payable  Wages,benefits, payroll taxes payable
(Cost of sales  Selling, general and administra tive expenses)/365
Cash Conversion Cycle
Given the following information about Vision
Opticals, compute the firm’s cash conversion cycle.
Inventory
Accounts Receivable
Accounts Payable
Wages, Benefits, Payroll Taxes
Sales
Cost of Sales
Selling & Other Expenses
$19,000
$21,000
$5,600
$9,000
$227,000
$93,000
$22,000
Inventory Conversion Period
Inventory
Inventory
365
conversion 

Cost of Sales/365 Inventory turnover
period
Inventory
$19,000
conversion 
 74.57 days
$93,000/365
period
Receivables Collection Period
Receivable s
collection
period
Receivable s
365


Sales/365
Receivable s turnover
Receivable s
collection
period
$21,000

 33.77 days
$227,000/365
Payables Deferral Period
Payables
deferral 
period
Accounts payable  Wages,benefits, payroll taxes payable
(Cost of sales  Selling, general and administra tive expenses)/365

$5,600  $9,000
 46 .34 days
($93,000  $22,000 ) / 365
Cash Conversion Cycle
Cash
Inventory
Receivable s
conversion  conversion  collection
cycle
period
period
Payables
 deferral
period
Cash
conversion  74.57 days  33.77 days  46.34 days
cycle
 62 days
Cash Management
How much liquidity (cash plus marketable
securities) should the firm have?
What should be the relative proportions of
cash and marketable securities?
Demands for Cash
Transactions demand
Precautionary demand
Speculative demand
Compensating balances
Short-Term Investment
Alternatives
U.S. Treasury securities

T-bills, T-notes, and T-bonds
U.S. federal agency securities
Negotiable certificates of deposit
Short-term tax-exempt municipals
Bankers acceptances
Commercial paper
Preferred stock & money market preferred stock
Other Factors in Cash
Management
Compensating balance requirements
Optimal amount of marketable securities
transaction costs
 maturity
 risk
 yield

Special tax situations
Float
Float is the difference between the available (or
collected) balance at the bank and the firm’s book
or ledger balance.
Disbursement float occurs when the firm writes a
check but the check has not yet cleared the
banking system.
Collection float occurs when a check has been
deposited but the funds are not yet credited to the
firm’s bank account.
Float Management Techniques
Wire transfers
Zero balance accounts (ZBAs)
Controlled disbursing
Centralized processing of payables
Lockboxes
Lockbox Systems
Discount Music Stores is evaluating a lockbox
system which will reduce float by 3 days. The
lockbox system costs $15,000 per year. The
firm’s daily collections average $150,000, and
its opportunity cost of funds is 6% per year.
Should the firm utilize this lockbox system?
Lockbox Systems
Funds freed up due to a reduction in float =
(3 days)($150,000 per day) or $450,000.
Annual value of float reduction =
$450,000(6%) = $27,000.
After deducting the $15,000 cost of the
lockbox system, the firm nets $12,000
before taxes.
Short-Term Financing
Trade Credit
Secured and Unsecured Bank Loans
Commercial Paper
Cost of Trade Credit
Discount Music Stores buys its inventory on “3/10,
net 30” terms. What is the cost of not taking the
discount?
Suppose DMS buys $1,000,000 worth of inventory; if they forgo
the 3% discount to pay on day 30 they are borrowing $970,000
for 20 days and paying $30,000 interest:
0
+$970,000
–$1,000,000
10
30
Cost of Trade Credit: APY vs. APR
Discount %


APY  1 

 100%  Discount % 
365
Total Period DiscountPeriod
1
Discount %
365



APR  



100
%

Discount
%
Total
Period
Discount
Period



Cost of Trade Credit: APR
0
+$970,000
–$1,000,000
10
30
 $30,000   365 
APR  
  20 days 
$
970
,
000



APR  56.44%
Cost of Trade Credit: APY
0
+$970,000
–$1,000,000
10
30
$1,000,000
$970,000 
20 365
(1  r )
 $1,000 
r 

 $970 
(1  r )
365
20
20 365
$1,000

$970
 1  0.7435  74.35%
Effective Use of Trade Credit
Advantages:
Readily available
 Informal
 Flexible
 Stretching payments

Disadvantages
High cost of discounts foregone
 Stretching of payments can hurt reputation

Bank Loans
Short-term unsecured loans
Transaction loan
 Line of credit
 Revolving credit agreement

Term loans
Bullet maturity
 Balloon payment

Cost of Bank Loans
Prime rate + “spread”
LIBOR + “spread”
Compensating balances
Compensating Balance
Requirements
Let





P = amount of loan
f = loan term
r = interest rate on loan
B = incremental cash balance as a result of
compensating balance requirements
y = interest earned (if any) on compensating balances
Interest charges = rPf
Interest received = yBf
Compensating Balance
Requirements
 Interest charges - Interest received   1 
APR  
 f 
Loan
amount
compensati
ng
balance

 
 rPf  yBf

 PB
 1 
  f 
 
Compensating Balance
Requirements
Custom Controls is considering a 1-year loan
of $150,000 at an interest rate of 14%. Due to
compensating balance requirements, Custom
Controls will have to maintain a deposit
balance of $20,000 which it would not have
otherwise maintained at the lending bank. The
deposit will earn 6% per year.
What is the APR of this loan?
Compensating Balance
Requirements
 rPf  yBf
APR  
 PB
 1 
  f 
 
 0.14  $150,000  0.06  $20,000  1
APR  
 1
$
150
,
000

$
20
,
000

 
= 15.23%
Without the 6% yield on the compensating balance,
the APR = 16.15%
Discount Loans
The interest charge is deducted in advance for
discount loans.
Let
r = interest rate on the loan
f = the term of the loan
P = the principal amount
The APR of a discount loan is given by:
 rPf   1 
r
APR  




 P  rPf   f  1  fr
A Comparison of Single Payment
Loans
Ole Tools Inc. needs to borrow $5,000 for 6 months.
Four single payment loan alternatives are available as
shown below. In each case, the interest rate is 15% per
year. Compute the APR and APY of each alternative.
Loan
Interest Payment
Compensating
Balance
A
B
C
D
in arrears
in arrears
in advance
in advance
No
Yes (10%)
No
Yes (10%)
A Comparison of Single Payment
Loans
Interest charge on the loan is
$5,000× (.15) ×(0.5 years) or $375.
 For loans A & B, this amount is added to the
repayment at loan maturity.
 For discount loans (loans C & D), this amount
is deducted from the loan amount at loan
initiation.
Compensating balances (for loans B & D),
is
$5,000×0.10 = $500.
A Comparison of Single Payment Loans
Loan
A
B
C
D
CF0
CF1
APR
$5,000
 375   1 
 15%
($5,375) APR  



 $5,000   .5 
$4,500
 375   1 
 16.67%
($4,875) APR  



 $4,500   .5 
$4,625
 $375   1 
($5,000) APR   $4,625   .5   16.22%

 
$4,125
 $375   1 
 18.18%
($4,500) APR  



 $4,125   .5 
A Comparison of Single Payment Loans
Loan
CF0
CF1
A
$5,000
($5,375)
APR
15.00%
APY
2
 $5,375 
 1
15.56%  
 $5,000 
2
B
$4,500
($4,875)
16.67%
 $4,875 
17.36%  
 1
 $4,500 
2
C
$4,625
($5,000)
16.22%
D
$4,125
($4,500)
18.18%
 $5,000 
16.87%  
 1
 $4,625 
2
 $4,500 
 1
19.01%  
 $4,125 
Discounted Installment Loans
Sheridan Systems borrows $12,000 for 3
months at 15%. The interest is paid in
advance, and Sheridan will pay the loan in 3
monthly installments of $3,000 at the end of
the first two months and $6,000 at the end of
the third month.
Compute the APY and APR of this loan.
Discounted Installment Loans
The interest cost of this loan is
($12,000)(15%)(3/12 years) or $450.
Since the interest is deducted in advance,
Sheridan will get $12,000 - $450 or $11,550
at loan initiation.
Discounted Installment Loans
+$11,550
0
–$3,000
–$3,000
–$6,000
1
2
3
$3,000 $3,000 $6,000
$11,550 


2
1 r
(1  r ) (1  r )3
r  1.72% per month
APR  12  0.0172  20.6%
APY  (1.0172)  1  22.68%
12
Commercial Paper
Commercial paper is a negotiable business IOU
note.
It is sold by the largest, most creditworthy firms
on a discount basis.
Maturity is set to less than 270 days.

Registration with the SEC is not required.
40% of commercial paper is sold through dealers.

Commission of about 0.125% on an annualized basis.
Factors Affecting the Short-Term
Financing Mix
Cost of each source of funds / incl’g options
Desired level of current assets
Seasonal component of current assets
Extent of maturity-matching
Flotation costs
Restricted access to long-term capital
Bankruptcy costs
Firm's choice of risk level